Variable Annuities – NO! YES!
Every fee-only financial advisor is required to take an oath swearing that they will make nasty comments about variable annuities every chance they get. I am certainly a member of that club, and when I was once asked whether variable annuities were a good idea for anyone, I replied, “Absolutely: they’re a great deal for variable annuity salesmen.”
A very good summary of the case against variable annuities was made by my friend, Andrew Tobias, in his magnum opus, listed on my book recommendations page. A typical variable annuity includes a combination of high expenses, extensive restrictions on access to funds, big penalties for changing your mind, and limited investment choices. What the investor typically gets in return is a temporary postponement of taxation that is only slightly better than what can be obtained by buying and holding investments in a taxable account, followed by the assessment of ordinary income tax rates on the money, much of which could have faced either favorable dividend or long-term capital gains rates or, if inherited, no income taxes at all. The net effect over a person's lifetime could easily be to cut their spendable net worth in half or worse.
When I get a new client who was previously victimized by one of these products, my objective is usually to help them decide whether to (1) just pull out all the money and take their tax and penalty lumps (often, when you make a mistake, the best thing to do is just pay the price and move on) or, if the cost of such an action is too high, to (2) find a way to execute a tax-free exchange of the assets to a different variable annuity with rock-bottom expenses (the variable annuity offered by Vanguard comes to mind).
But ...
At the risk of getting myself kicked out of the I-Hate-Variable-Annuities club, I must admit that there is one circumstance in which it just might be the perfect solution for a person. Even though I'll regret it for the rest of my life if I add just one more name to the enormous list of people who inappropriately chose a VA, I'd also feel bad if the justified prejudice against this product prevents it from being used in the one case that it could be a lifesaver.
So who is that person? Well, it would have to be someone who meets the following 3 criteria:
(1) Retired or about to do so (right off the bat, that should eliminate most of the people reading this)
(2) Without any goal to leave a significant financial legacy to heirs or charity (that should rule out almost anyone with children as well as anyone who feels very passionate about helping a particular charitable group, although there still might not be such a goal if the next item makes inheritance an unrealistic objective)
(3) In danger of running out of assets if they and/or their partner live too long (take your desired annual spending, subtract social security and guaranteed pension benefits, and multiply the result by 20: if you have more than that in investment assets, you probably don't need to worry)
That last item is, of course, variable: a person might have enough to live adequately without frills and if nothing major goes wrong, but still be in danger of running out if they pursue the lifestyle they want or have major expenses. Make reasonable estimates for a comfortable lifestyle and include the costs of insurance against nightmare scenarios if feasible.
Okay, so what is special about a person meeting these 3 criteria that suddenly makes a variable annuity a good choice (at least for a part of their assets)? It is that they can ANNUITIZE THE ANNUITY! The original idea behind an annuity was to provide someone with regular payments for life (or some other specified period, but we're going to assume life here). With an annuity, the person can give their money to the insurance company and, in exchange, have guaranteed payments for life, which eliminates the most infuriating aspect of deciding how to spend down your assets: YOU DON'T KNOW THE DAY YOU'RE GOING TO DIE.
I am working with a gay couple: one of the guys has retired and the other is about to retire. They've been together for decades and, while they both earned decent money, they also enjoyed themselves without thinking much about the distant future. Well, here we are in the distant future, and now they want ME to figure out how they're supposed to have adequate income for the rest of their lives. They've only got about $300,000 in total savings, mainly in employer profit-sharing plans they forgot to spend. That's not a lot, but both will get social security based on their work careers, the house is paid off (and, of course, decorated beautifully), and now the question is how long they need to make that $300,000 last. Now, if I knew for a fact they'd both die in 5 years, I could just tell them to spend $60,000 per year (well, a little more, since we could put the money into low-yielding CDs or Treasuries until needed), and if I knew for a fact they'd live 20 years, I could tell them $15,000 plus estimated earnings. The problem is that they (or at least one of them) might make it 30 years, and now we're down to $10,000 plus earnings. Which is really pretty lousy. Worst of all, they're both in good health.
Okay, we can help the cash flow by a reverse mortgage on the house (a topic for another day). Still, it isn't so much a question of what they NEED, but what they can afford to spend without taking unreasonable risks. Variable annuity to the rescue: a variable IMMEDIATE annuity. We're going to start by annuitizing the money in the employer plans using the Vanguard Lifetime Income program based on their joint life (since two live cheaper than one, the loss of social security on the death of one is about all the other could bear on top of the loss of their partner). And now they know exactly how long the money is going to last: as long as it needs to last.
One thing, though: the annuity is not going to be fixed payments each year. The money in the tax-sheltered plans in a traditional fixed annuity might guarantee $15,000 per year, but $15,000 won't buy as much a decade from now as it does today, assuming inflation. And what if the inflation is really high? Each life is only one experiment, and we don't want to just deal with the one risk related to longevity: we have to deal with the other related to inflation. And while there are inflation-adjusted annuities available, a variable annuity is my preference: even after converting the payments to an income stream, the money will continue to be "invested" in a combination of mutual funds that should grow faster than inflation. Sure, it will be variable, but they can make small changes in the amount of travel they do if the markets go down, and might be able to splurge if they go up, and they have reasonable expectations with proper diversification. We might not annuitize ALL the assets in this case, but we could later if we need to boost the cash flow.
There was absolutely no reason to use a variable annuity during the accumulation phase: the money in the employer plan was sheltered from taxes anyway, and the money in taxable accounts could take advantage of the low rates on dividends and long-term capital gains during the accumulation years. Besides, during the accumulation phase, you don't really know if you will fit into the 3 criteria that make it a good choice in the spending phase.
So the real villain is the variable DEFERRED annuity, where you're paying unnecessary expenses on money that isn't being annuitized. The possible hero is the variable IMMEDIATE annuity, IF you meet all 3 criteria and you're ready to convert it to periodic payments.
Let me note that there are even more complications with variable annuities than I implied in this piece, and you shouldn't make a decision without learning in detail exactly what will happen as well as what alternatives might be even better in your situation. Also keep in mind that, even in the case I described, the variable annuity that you'll want to buy WON'T be the annuity that any salesman wants to sell you, because there are going to be a lot of extra fees in that one and the investment choices probably won't be great and there might be a lot of penalties for changing your mind. Vanguard doesn't offer their product through salesmen getting commissions (nor do T. Rowe Price or Fidelity, two other fine providers). That's why you probably will only hear about the best annuities from a fee-only advisor: since they don't get a referral fee or commission for recommending any particular annuity, they have no reason to consider anything other than the benefit to their client.
